From the UK: Industry and Regulators Respond

to the Liquidity Crunch

Regulators Respond

When inter-bank lending froze in the wake of the failure of Lehman Brothers, it quickly became apparent that capital was an inadequate response to a liquidity crisis. Regulators have been quick to note this and a slew of regulations are now expected around liquidity risk management.

  • The FSA in the UK was the first to act, publishing a consultation paper in December 2008 that set out new liquidity standards for banks operating in the UK. The FSA then released two more papers in 2009 – one in April and the other in June. A paper outlining the FSA’s policy statement on the new liquidity standards was issued in October 2009, which reaffirmed the regulator’s intention of continuing with the new liquidity standards it had consulted on before.
  • The Committee of European Banking Supervisors (CEBS) published their ‘draft guidelines on liquidity buffers’ in a consultation paper (CP28) issued in July 2009. Apart from the absence of a self-sufficiency clause (the most contentious aspect of the FSA guidelines), the CEBS paper’s approach and guidelines are very much along the lines of those issued by the FSA.
  • On 09 December, the Basel Committee on Banking Supervision approved a package of proposals for consultation to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector. Comments on the consultation documents should be submitted by April 2010, and the measures would likely be put into force by 2012.

 

The acute liquidity crunch in the days and weeks following the failure of Lehman Brothers in the autumn of 2008 has shown the importance of liquidity to financial institutions in general, and banks in particular.

On a day to day basis, the primary source of liquidity risk in a firm would be any payment mismatches on its assets and liabilities. A firm hits a crisis when that mismatch grows significantly and unexpectedly against the firm, i.e. the firm faces massive payment demands or outgoing cash flows, to a point where it cannot match demand and therefore fails to meet obligations in the short term. Such a crisis is serious even if the firm may be otherwise solvent; the firm will then need to take drastic measures to survive what would most certainly result in an erosion of value.

Beyond Traditional Analysis

The Asset Liability Committee (ALCO) of a firm has traditionally looked to mitigate and manage this risk with gap and duration analyses available in most Asset Liability Management (ALM) software. While this may have worked in the past, gap analysis and duration analysis have both proven inadequate in terms of preparing for a crisis; as shown by the credit crunch in late 2008. Firms took on enormous duration risk by increasing their reliance on wholesale funding markets, based on the assumption that those markets would always function. ALM looks at duration risk from the earnings perspective and, as a consequence, at capital.

  • Firms generate a spread by borrowing short-term and lending long-term
  • This spread is exposed to changes in the interest rate
  • Spreads could tighten if short-term interest rates rise, leading to lower earnings or even to a loss, and to an erosion of capital

Gap analysis, on the other hand, looks at the impact of mismatched cash flows, which brings it close to assessing the risk of illiquidity. However, the assumption traditionally has been that liquidity would always be available and that the impact of cash flow gaps is an increase in costs (and as a consequence reduced earnings). The possibility of liquidity simply being unavailable, however, is no longer remote and traditional gap analysis needs to be taken a step further.

The models used by banks until now were meant to assess the risk covered by the capital they hold. This was certainly true for the duration risk arising from the funding model they adopted. However, the recent crisis has shown a new avenue for failure. A bank could be extremely well capitalised, but inadequately liquid – as with Northern Rock in Great Britain in 2007.

Outlining Implementation

While regulatory requirements will vary across regions and local jurisdictions, two aspects appear to be common to all regulations emerging around liquidity risk:

  • Firms are required to hold a buffer of liquid assets to cover unexpected liquidity demands
  • That buffer will have to be of an as-yet undetermined amount

Regulators are keen on ensuring that the assets held in these buffers are adequate given the business and that the assets are not only liquid now, but will also continue to be just as liquid in a crisis. It appears that the only assets that would qualify are high-quality sovereign debt, with even cash held in a bank being considered subject to liquidity risk.

While no regulator has outlined a methodology that firms could employ to determine the amount of liquid assets they need to hold, both bodies clearly agree that stress testing is an important component. Firms will be required to stress their liquidity profiles to determine the extent of risk they can sustain. The regulator could then compare that level to the firms’ peer group to determine the extent of risk the firm poses the financial system.

The FSA in the UK, for instance, has termed this process the ‘Supervisory Liquidity Review Process’ (SLRP), the outcome of which will be an ‘Individual Liquidity Guidance’ (ILG) for the firm. The ILG will:

  • Give firms insight into the FSA’s opinion of the firms’ liquidity profile relative to their peers
  • Outline to each firm the size of the liquidity buffer the FSA expects them to hold

The supervisory process in other regions will probably not vary significantly from this.

Implications for the Industry

Apart from the regulatory aspect, there is the fact that a firm that is better at managing its liquidity will improve its competitiveness in a market that is already seeing unprecedented stresses. The liquidity buffers firms are now expected to hold of course add to the cost of doing business, while margins are already stretched in difficult circumstances. Therefore, firms must:

  • Optimise the amount of liquidity buffer they have to hold
  • Leverage it in the best way possible
  • Understand to what extent each of their product groups or organisational units contribute to this cost

The new requirements pose new challenges and costs to firms in terms of their implementation, in addition to the cost of holding liquid assets. A key challenge now lay in determining the appropriate mechanism for determining the firm’s liquidity profile and in stressing this for adverse conditions.